Economist expects uptick in recovery

In his annual BizTimes Economic Trends forecast for 2014, economist Michael Knetter expects the U.S. economy’s “long and slow” recovery to continue, but he anticipates that the pace of that recovery will pick up this year.

Knetter, who is the president of the University of Wisconsin Foundation, served as a senior staff economist for the Council of Economic Advisers for former Presidents George H.W. Bush and Bill Clinton.

Knetter presents his macroeconomic overview every year at the Northern Trust Economic Trends Breakfast presented by BizTimes Media.

BizTimes executive editor Steve Jagler interviewed Knetter in advance of the breakfast. The following are excerpts from that interview.

BizTimes: Going forward, I want to start with the Federal Reserve’s recent decision to begin tapering its stimulus program. Wall Street seems to be taking it as a sign that the economy really is recovering. What’s your take?

Knetter: “The economy continues its long, slow recovery. The Fed has been clear that it would like to return to a more conventional monetary policy, and I think it is prudent to begin that process. I think Wall Street is every bit as aware of the state of recovery as the Fed, so I think Wall Street is reacting more to news about Fed intentions in the face of new Fed leadership than to any implicit information that announcement may contain about the true state of the economy.”

BizTimes: So, let’s get right to the bottom line: What do you foresee the Gross Domestic Product doing in 2014 and why?

Knetter: “I’ve been overly optimistic the past two years that we might find our way back to 3-percent real GDP growth. We have failed to make it due largely to fiscal contraction from governments. I think we will make it this year, but it will depend in part on the pace of Fed tapering, any associated change in interest rates, and the reaction of firms and households to rate changes.”

BizTimes: The stock market has been posting record highs in the past couple of months. What does Wall Street know that maybe the rest of us don’t know?

Knetter: “Wall Street knows the return on capital, which is different than real GDP or employment growth. While GDP has staggered out of the Great Recession, corporate profits have done very well and are projected to be strong going forward. Strong corporate profits are mainly the result of well-managed businesses – firms have protected margins and have captured share in growing foreign markets. So even though GDP has been a bit sluggish, firms have posted strong earnings. A third factor that has helped, in my opinion, is the simple fact that people have to put their savings somewhere. Broadly speaking you can invest in U.S. or foreign equities, U.S. or foreign bonds, or your bank account. I think U.S. equities have looked like the best alternative for quite some time, partly due to the low rates available on fixed income investments. There may still be more upside ahead for U.S. equities because I think many people were slow to get back their risk appetite in the wake of the 2008-09 experience. If people continue to regain their appetite to be in risky assets, then the market may continue to have a nice tailwind this year due to flows into stocks.”

BizTimes: The uncertainties of the impact of the Affordable Care Act seem to be giving many business leaders pause for concern. Ultimately, how do you see it all playing out?

Knetter: “The rollout had many well-documented problems, but that is not so surprising given the scale of the project. The big uncertainty that remains is how the Act will affect the total cost and quality of our health care, and also how it will affect the incentives of key decision makers in the economy – including households, smaller firms and entrepreneurs. In the end, I do not see how the Act increases the supply of health care nor contains the most costly elements of the health care system. So I think the overall cost of health care in our economy will remain high and there will be somewhat expanded coverage. I think we will need more changes in order to increase supply and control costs.”

BizTimes: As you know, the national unemployment rate has been stubborn. It’s been slow getting that thing to shrink. What do You see it doing in 2014, and what would need to happen for the economy to make progress in bringing it down?

Knetter: “I would expand on your statement a bit because the unemployment rate has actually performed better than the overall employment situation because part of the decline in unemployment has been a result of a decline in labor force participation. Labor force participation is the share of working age people who are working or actively seeking work. It has declined by a full three percentage points since the start of the Great Recession. The employment to (working age) population ratio has fallen by nearly four percentage points. At labor force participation rates of 2008, the unemployment rate today would remain near 10 percent.

“I think there are three things going on that help explain the declining share of employed people who are of working age. First, the rebuilding of balance sheets from an over-indebted situation of several years ago has reduced demand for goods and services (i.e., recession-like conditions). Second, changes in technology have made many jobs somewhat obsolete and thus many workers less valuable than they had been previously. Workers affected by this may have expectations about their value that are not met by the job offers they can attain. So they extend their search or simply exit the workforce. Finally, there have been temporary support measures for unemployed workers that can extend the search process. Essentially, not being part of the formal workforce can become relatively more appealing if we increase benefits to those who are not working. Life has become more challenging for less skilled working age people due to increased global competition and technological changes. The attractiveness of working or being in the workforce has accordingly fallen. This is a real economic and social challenge for the nation.”

BizTimes: Many economists have made note recently of the growing gap in wealth between the very rich and the poor, while the middle class seems to be losing ground. What’s your take on the income disparity gap?

Knetter: “The distributions of income and wealth have widened considerably in America. Some of this is a reflection of changes in the labor market. Highly educated workers have benefitted more from the defining economic trends of globalization and technological changes. In addition, the returns to new business formation at a time of great technological change have grown and created many millionaires/billionaires. Most people who have found their way to great economic success – let’s say the proverbial 1 percent – have done so through considerable personal effort and in this era, being connected to work 24/7. The rewards have been greater than what we have seen for success in the past, but so have the foregone opportunities of more family time and personal freedom. And it is also true that whatever you consider someone’s ‘fair share,’ most people with high earnings and wealth are paying a large amount in taxes to support benefits of all kinds for many other people. And in spite of that, they probably feel envied or even resented by those who benefit most from their tax payments.

“But the envy of others toward those who have done well is equally understandable. Most people who are not able to land high-paying jobs still want to be able to have rewarding and meaningful work that pays a decent wage. Their opportunities seem to have become scarcer due to foreign competition. Real incomes for many sectors of the economy do seem to have stagnated. Today’s blue collar families will struggle much more to send their children to college and to have the kind of retirement their parents did. The ladder of opportunity in America looks pretty rickety today. That seems unfair to people. I think the communication gulf between these two groups of people is even greater than the economic gulf. Many prosperous firms in the new economy are comprised almost entirely of college educated (or higher) workers – e.g., Google, Microsoft, or closer to home, Epic. These are different than manufacturing businesses that paired engineers and management with blue collar workers on a single team. The traditional manufacturing business ensured some degree of shared progress as well as regular communication across different types of workers. I think the gulf we see in our politics today is related to the increased economic disparity and economic segregation.

“It is not clear there is any way to change the trends in income distribution. But there are ways to try and preserve some degree of equality of opportunity for children of all backgrounds. It will be important for children who grow up in lower income families to have a reasonable shot at attending college and acquiring the skills that can give them economic mobility. To me, that is the core of the American dream.”

BizTimes: The federal minimum wage has not come close to matching the rate of inflation. What would be the economic impact of raising the minimum wage?

Knetter: “I really don’t think it would have a very big effect on employment or on the overall distribution of income. Given we have a minimum wage, we ought to consider adjusting for cost of living. That might make those jobs more attractive for some people.”

BizTimes: Wisconsin’s economy continues to rely heavily on manufacturing and agriculture. Those have been economic assets in recent years. Will that continue?

Knetter: “I think it will continue. Wisconsin’s manufacturers have done a great job of remaining competitive in advanced manufacturing areas and some traditional areas of strength such as paper and auto parts. And agriculture has added to its traditional strength by finding some lucrative niche markets for organics and premium cheeses, among other things. This success will rely on our firms and farms continuing to move up the quality ladder.”

BizTimes: What do you see ahead for the world economy, specifically Europe, China and Japan? And what impact will the world’s economy have on the U.S. economy?

Knetter: “I think growth in the rest of the world will generally exceed growth in the U.S. in the years to come as developing markets gain ground technologically. This will allow U.S. incomes to grow faster than domestic demand alone would permit.”

BizTimes: Finally, American college students are graduating and starting their professional lives with record amounts of debt. Trust me, I know. Are you worried about that?

Knetter: “A few thoughts on this subject. First, it is OK to have some ‘skin in the game.’ So I am not worried about students taking on some debt for their education. I was never more motivated to make the most of my own education than when I had to pay the first year of graduate school at Stanford out of pocket. It was worth every penny, but partly because I made sure of that. Second, if we are pushing students through school with more of the burden on them and their parents (and surely that is the case), then we owe them better information about the economic returns they can expect from their educational choices. We should not have a system that awards substantial loans without a clear sense of an ability to pay the loans back. That, in turn, requires an understanding of the economic prospects a person has in light of (his or her) educational choices. Third, I am most concerned about the young people who are not able to pursue an education because the financial costs are too prohibitive – as opposed to those who go and accumulate debt. We need to do a better job of providing affordable options for all students who want to build their human capital. We can do that but it will take a real effort at reform.

“Finally, I am pleased that students graduating from UW-Madison and the UW System have much more reasonable debt burdens, if any at all. We regularly rank near the best schools in value per dollar of cost and among the lowest debt loads of graduates. About half of the graduates at UW-Madison leave with debt and of those that do, the median level is around $25,000.”

BizTimes: Is there anything else on your mind that you would like to comment about?

Knetter: “A remaining mystery in the economy today is why the massive expansion in the Fed’s balance sheet has not yet caused any hint of inflation or even much expected inflation when you look at the yield curve. One reason we do not see current inflation is the remaining slack in the labor market. I am more puzzled why we don’t see a real uptick in long-term expected inflation. I think one reason is that our Fed expansion has been matched (or in Japan’s case, exceeded) by central bank actions in many other countries. As a result, we have not seen any depreciation of the dollar that might normally accompany such extreme central bank actions. That eliminates one of the normal channels for inflation to occur in the wake of monetary expansion. It also suggests that we might see more inflationary pressure occurring in these countries if one or more of them begin to reign in the stimulus before the others. That may be one of the reasons why the Fed is signaling a desire to dial back the asset purchases sooner rather than later.”

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